Automobile Leases and the North American auto market are currently (Aug 2008) in the news and some people predict the demise of auto leasing. I don’t think so, read on and see why.

Suppose you lease a $20,000 vehicle for 2 years with monthly payments of $417.29. You may think this is fair and reasonable. What is the leasing company making from this deal? After 2 years the $20,000 vehicle is worth $13,000 (known as the residual) thus the depreciation of the vehicle is $7000.

In reality you are borrowing money to pay for the depreciation. If you were to borrow $7000 for two years at an interest rate of 37% the monthly payments would be $417.29. Consider that Oil companies make returns in the 10% to 15% range and they are allegedly greedy. Obviously nobody would knowingly agree to a 37% lease interest rate.

What is curious is that someone would think nothing about signing an auto lease at 9% for two years on a $20,000 automobile with a residual value of $13,000. The residual value is what the lease company can sell the car for when you return it to them in good condition.

The lease payments would be $417.29 per month and monthly interest is being calculated on an initial Principal of $20,000 even though in reality you are only borrowing $7000 because the lease company gets back a vehicle worth $13,000 at the end of the lease (residual). As stated earlier borrowing $7000 for two years with monthly payments of $417.29 equals an interest rate of 37.06%

Residual values on leased gas guzzlers are currently dropping dramatically. It is understandable the lease companies have risks and costs but in this example the real interest rate you are paying is over four times the quoted lease rate. This also holds true for this example at a 3% lease rate and a 6% lease rate over the two years.

9% in effect is approximately 37%
6% in effect is approximately 25%
3% in effect is approximately 13%

If you lease you are paying increased interest costs for the chance to drive more car with lower monthly payments. Not to mention, lease payments are in advance each month. On top of that, some lease companies do not use this fair amortization method of calculation, a topic for another day.

It’s interesting to note, if the $20,000 automobile was purchased outright with a two year loan at 9%, the monthly payments would obviously be higher ($913.69)
but after two years you would own the car and would have paid $1,928.69 in interest costs instead of $3,015.06 via the lease option. Food for thought!